Tax cases in Sweden don’t normally get pulses racing, but the trials and tribulations of one of Nordic Capital’s subsidiaries through the Swedish administrative courts have been followed with keen interest by private equity houses.

At stake was how carried interest, a key way that private equity executives get paid, should be taxed. Once profits in a fund exceed certain levels, firms are entitled to a slice, called carried interest, which is distributed among their executives. Typically, it is around 20% of profits over a certain level, and can amount to hundreds of millions of pounds.

At the heart of the Nordic Capital case was a debate that has been held in many countries – is carried interest income or a capital gain? How carried interest is treated can make a big difference to private equity executives’ pay packets. In the UK, carried interest is treated as a capital gain, so is taxed accordingly at 28% rather than the higher rate of income tax of 45%.

The Swedish authorities said carried interest was a form of income so should be taxed at the higher rate of income tax, rather than the lower rate of capital gains tax. They also said private equity investment vehicles should be paying hefty social taxes, just as other companies do.

Last month, the test case reached its conclusion. The courts ruled in favour of Nordic Capital, saying that carried interest was not like normal income and that the firm did not have to pay retroactive taxes.

For Nordic Capital’s chief financial officer Klas Tikkanen it was an onerous case. At some points during the five-year battle he had to spend a third of his time working on the case. The firm’s subsidiary, NC Advisory, was on the hook to pay back taxes of Skr702 million ($108 million) and the firm had seven external lawyers and accountants working on the case. There were concerns that it would make it harder to coax investors to pledge money to its new €3.5 billion fund, which closed in December.

Tikkanen said: “Now the courts have said that the tax authority cannot reinterpret the law and that the tax authority should focus on applying existing law. If we would have lost, I think it would have had a negative impact on Swedish private equity broadly.

“The [authorities] were attempting an experimental style of legal process. For a while it made some of our potential investors a bit worried. But at the end of the day, people looked at it and got comfortable.”

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Many in the industry were worried that the case could set a precedent and that other European governments would follow suit and start to change the way they treated carried interest, according to Guy Dingley, counsel at law firm Covington & Burling.

Dingley said: “Obviously advisers are always worried about the floodgates argument, one jurisdiction effectively topples, then that gives a green light for the rest to follow.”

That sentiment was echoed by another adviser, who said the case had brought some unwanted scrutiny to the industry and fears that other jurisdictions would copy Sweden’s line.

She said: “If the Swedish tax authorities had succeeded there would have been worry of scrutiny on similar tax arrangements elsewhere. I think the private equity industry just wants to keep its head down, so the less focus on carried interest and fund managers benefiting from particular tax regimes, the better.”
The case in Sweden may have been settled, but that does not mean the issue of carried interest is off the table.

Major changes are being proposed as part of the Organisation for Economic Co-operation and Development’s Base Erosion and Profit Shifting rules. These new rules, which have yet to get the green light, have been prompted by controversy over the tax arrangements of multinational companies such as Google and Starbucks. The plans, which are still at an early stage, could affect carried interest. They propose aligning tax systems across countries and making sure that companies have proper substance in the jurisdictions in which they are taxed.

In the US, the issue of how to classify carried interest will not go away. Defeated presidential candidate Mitt Romney’s connections to Bain Capital brought the industry under scrutiny during the 2012 presidential election, with one advertisement by Barack Obama’s Democrats showing a worker at a Bain Capital-owned factory describing the firm as a “vampire”.

President Obama has carried interest in his sights. Last April he proposed a host of tax increases, including taxing carried interest as ordinary income in this year’s budget. Plans to levy the tax are being debated in Congress and, according to the Joint Committee on Taxation, the new rules would raise $17.4 billion in revenue in the financial years from 2014 to 2023.

What about the UK?

Advisers say if the US changes its taxes on carried interest then the UK could follow suit.

Fiona Cooper, tax director at global buyout firm Apax, said: “From a UK perspective, the US poses a greater threat to the treatment of carry than the EU. If certain politicians and press jump on the US bandwagon, there may be political pressure to do something similar here.”

However, Adam Frais, a partner at accountancy firm BDO, said: “There are very good reasons why carry is taxed as capital and it should remain so. I think it would be very hard, based on the current law, for the UK to say carried interest should be taxed as income.”

Helen Lethaby, a partner at Freshfields Bruckhaus Deringer, added: “The treatment of carried interest in the UK is well established. I don’t think anyone is on notice that the Revenue here are revisiting it or thinking hard about it.”

Instead of focusing on carried interest, politicians in the UK have been looking at more esoteric tax loopholes, changing the way that limited liability partnerships get taxed. Last September, Danny Alexander, Chief Secretary to the Treasury, said: “We will be closing the loophole that allows private equity shareholders to siphon money out of their firms while dodging the intended income tax.”

That led to changes to the rules on how partnerships are taxed in the 2013 Autumn Statement, which has caused some firms to rejig how they are set up and paid. And Deputy Prime Minister Nick Clegg has signalled that he wants changes to the “shares for rights” scheme.

Osborne’s pet policy under scrutiny

Dubbed a “gift from the taxman” by one lawyer at the time, UK Chancellor George Osborne’s “shares for rights” scheme has come under scrutiny since it was launched after the summer.

It was aimed at encouraging workers to take John Lewis-like stakes in the small and medium businesses that employ them. But in September, it emerged that the eight members of the senior management team at dried fruit supplier Whitworths had used the policy to reduce their tax bill when the company was sold by private equity house European Capital to Equistone in a £90 million deal.

Under the scheme, employees are offered shares worth between £2,000 and £50,000 that are exempt from paying capital gains tax, and in exchange they must give up some of their employment rights. On most private equity deals, portfolio company managers can buy shares in the company at a discount, which gives them an incentive to increase profitability so that their shares will be worth more when a buyout firm comes to sell the company. Lawyers said management teams that want to use this scheme can value some of their shares at a large discount, so falling under the scheme and avoiding capital gains tax.

After the launch of the scheme, several market watchers said buyout firms were being cautious about using it. One lawyer said that his client didn’t want to use it for “reputational reasons”.

Fiona Cooper, tax director at buyout firm Apax, said: “We were a little bit worried when it first came out that it may not be the government’s intention for it to apply to private equity.

But that squeamishness seems to be easing. Cooper added: “We discussed this among our peers and came to the conclusion that the government introduced this legislation and we have to take it at face value. If they had meant something different, they had the option in the Autumn Statement to revise it.”
Adam Frais, a tax partner at accountancy firm BDO, said he was “seeing more deals with it being used. But there are concerns on how long it will be around.”

Firms may not have long before the taxman clamps down on the scheme. This month, Deputy Prime Minister Nick Clegg tried to distance himself from the scheme, with the Financial Times reporting that he wanted to scrap the scheme and use the money to fund tax breaks for the low-paid.

--This article first appeared in the print edition of Financial News dated January 27, 2014